Unit 10: The Influence of Government Taxes and Regulations on Markets

The information covered thus far in this course shows how in a perfect world the “market” can efficiently allocate resources for the production of goods, use the price mechanism to stimulate production, and how changes in demand can affect what is produced as well as, force workers to leave a dying industry to move to a growing one.

But the world is not perfect. There are things that prevent the market from operating perfectly. Even though the market does not operate perfectly, it is still a more preferable system than a command economy. There are a number of factors that prevent a market from operating smoothly. Some of them are:

1) the market domination of monopolies and oligopolies (unit 5)

2) public goods (unit 7)

3) the existence of externalities (unit 7)

4) undesirable income and wealth distribution (unit 9)

These market failures all share a common solution” government intervention. But what does market failure mean? Market failure refers to situations where there exists waste in the market. In other words, we could produce more goods with the resources we have and supply more people with those goods if not for the inefficiency. Because of the existence of market failure, there is a call to have an outside agent (the government) to intervene and correct the economy. Government intervention in the economy is a controversial issue that will be explored in this unit.

One of the ways that the government touches everyone’s life is through fiscal policy. Using fiscal policy to influence the performance of the economy has been a tool used by governments since the Keynesian revolution in the 1930’s. Fiscal policy is the use of government spending and taxes to influence the nation’s output, employment, and price level. Fiscal policy focuses on matters within the government’s control. The government can expand the economy by increasing government purchases or decreasing taxes. These policies may be enacted during a recession. It can contract the economy by decreasing government purchases or increasing taxes. These policies may be enacted during a period of high inflation.

It is difficult to discuss the history of our nation’s fiscal policy without describing the effects of the Great Depression. The Great Depression of the 1930’s produced mass unemployment of up to 25%. There were cries for government to get involved and solve the problem. The demand for government involvement ran contrary to the belief of classical economists. Classical economists believe business cycles are temporary. The price system would restore an economy in depression to full employment without government involvement. At this time a British economist, John Maynard Keynes, developed an alternative solution for dealing with depressions. He argued that the economy is not self-correcting and required the government to play an active role to restore it. People who believe that a government can help get an economy out from a recession or a depression through the use of taxing and spending policies are called Keynesians.

Keynesian vs. Classical Economics

As mentioned above, the Great Depression had an enormous impact on economic thinking. John Maynard Keynes differed from classical economics on the notion of time. Keynes emphasized the importance of how the economy is performing in the short run, while classical economists focused on the long run. In simplest terms, Keynesians believe that government action is to remedy short-run economic problems. Classical economists on the other hand, believe that a steady policy of focusing on the long-term will best allow the economy to take care of itself. The essence of Keynesian thought is that the level of economic activity depends on the total spending of consumers, businesses, and government. If businesses and consumers are pessimistic about the future, spending will be reduced, which will result in layoffs and an economy moving into a prolonged recession or even a depression. The table below provides a summary of the two schools of thought.

Price and wages will adjust upward or downward as needed to reach a full-employment equilibrium. If unemployment is high, workers need to accept lower wages.

Prices and wages adjust upward without difficulty, but have problems adjusting downward and are thus unable to lead the economy to full employment. The government should step in with public works projects.

Fiscal Policy

Government should not attempt to manage the whole economy ( aggregate demand)

Government should actively adjust taxes and spending in order to mange the economy ( aggregate demand)

Shortcoming

Fixing unemployment requires patience.

Fixing unemployment can lead to demand-pull inflation.

How Keynesians and Classical Economists Would Fight a Recession/Depression Differently

Classical economists would say that the economy will self-correct to full employment in the long run. Keynesians would say that “we will all be dead” in the long run. Keynesians would attempt to increase aggregate (total) demand by increasing one or all of the components of GDP ( C + I + G + X ). Since the government has control over government spending, they can increase or decrease it as necessary. If the government is buying goods, someone has to make them. That means they have a job and a steady income. That means they can use some of their income to make purchases of goods, goods made by someone else who gets a paycheck etc… The Keynesian approach is vastly different from the Classical approach. Classical economists would stress that the government needs to stay out of the economy and remain on the sidelines. this will allow market forces (unemployed workers competing for jobs makes wages more flexible) which would then restore the economy to full employment.

There is a second choice for both Keynesians and Classical economists to combat a recession. They can cut taxes. A cut in taxes will increase disposable personal income. This means consumers would have more money to spend. That means they could purchase more goods. These goods have to be made by someone, so that helps the employment situation. Briefly put, this increase in personal income causes us to increase consumption spending. This results in a chain reaction of spending called the tax multiplier. The tax multiplier is the change in aggregate demand (total spending) resulting from an initial change in taxes. However, this does not always work. Sometimes people save instead of spend. Another problem with cutting taxes is which groups of taxpayers will benefit the most. Democrats, who are largely Keynesians, have traditionally tried to reduce taxes on the poor, while Republicans, who are largely favor Classical economics, have believed in reducing the taxes on the wealthy.

Supply-Side Economics

Supply-side economists, with their roots in classical economics, argue that fiscal policy should emphasize government policies that increase aggregate supply in order to achieve long-run growth in output, employment, and the price level. For supply side economics to work, the government must implement policies that increase the total output that firms produce at each and every price level. An increase in aggregate supply can be accomplished by some combination of cuts in resource prices, technological advances, subsidies, and reductions in government taxes and government regulations. Supply-side economists believe the economic role of government is too big, and that tax rates and government regulations prevent businesses and individuals from producing more goods and services. The solution? Get government off the backs of individuals and businesses by cutting taxes and reducing regulations.

President Reagan experimented with supply-side economics in the early 1980’s. He implemented tax cuts. By reducing tax rates on wages and profits, he was hoping to increase the aggregate supply of goods and services at any price level. This helps to increase disposable income. Now you might be thinking, hey, this sounds like Keynesian economics to me. And you would be right. The difference lies in that Keynesians believe the extra disposable income works through the tax multiplier to increase aggregate demand, whereas the supply-side economists believe the extra disposable income will affect the incentive to supply work, save, and invest. Supply-side theory says that the increase in income from tax breaks stimulates the incentive to work longer hours and take fewer vacations. Supply-siders say that there is a work-leisure debate that workers confront. Should a worker work overtime? Take on a second job? Keep a store open longer hours? If the worker believes that if they do this extra work they would only be working for the government, then the answer is probably no. The theory also says that because the government takes out less taxes from your paychecks more new workers will offer their labor. Supply-siders also favor tax breaks that subsidize business investment. The idea is to increase the nation’s productive capacity. Businesses have an extra after tax profit incentive to invest.

One of the main ideological foundations of support for supply-side economics comes from the Laffer Curve. The Laffer Curve is a graphic representation of the relationship between increasing tax rate and government’s total revenues. This relationship suggests that revenues decline beyond a peak tax rate. The relationship suggest that revenues decline beyond a peak tax rate. The idea was quickly seized upon by leading Republican conservatives, who used it to justify major tax cuts in the early ’80s and have continued to do so ever since.

It has long been said that the only thing one could be sure of in life is death and taxes. Since taxes are an important factor in our lives, it would be beneficial to the student to understand the nature of our tax system. The information below is designed to meet that end.

Governments collect taxes to pay for government expenditures. Government expenditures are federal, state, and local government outlays for goods and services. Government expenditures have increased dramatically since the 1950’s. Consequently, so has the amount of money sent in to the various levels of government in the form of taxes. The government’s share of total economic activity has increased faster than the private sector’s since the end of World War II. Because the citizens of our country have increasingly looked to the government to solve problems, the percentage of our incomes devoted to paying taxes has increased. Although it is commonly believed that citizens in the United States pay too much in taxes, we do have a lower overall tax burden that most other industrialized countries.

There are two main taxation philosophies. Each tries to look at efficiency and fairness. The first is the benefits received principle. This idea of taxation believes that those who benefit from government expenditures should pay the taxes to finance their benefits. From this viewpoint the ideal tax would be a user charge. Examples would be the gasoline tax or fees to use a state park. This philosophy seems to work well with private goods. The problem with this philosophy is the question of how to pay for public goods such as national defense and welfare. The second philosophy is the ability to pay principle. This idea of taxation believes that those who have higher incomes can afford to pay a greater proportion of their income in taxes, regardless of benefits received. This policy is more popular in our society, than the benefits received principle. An example would be income taxes.

Types of Taxes

Governments raise revenues from various taxes such as income taxes, sales tax, and excise taxes. These taxes can be categorized as either progressive, regressive, or proportional.

Regressive. A regressive tax is a tax that charges a lower percentage of income as income rises. Examples of regressive taxes are sales, excise, and social security taxes. For example, if person A makes $50,000 and pays $5,000 in taxes, then the $5,000 represents 10% of his/her income. If person B makes $150,000 and pays $10,000 in taxes, the $10,000 would represent 6.6% of his/her income. Regressive taxes place a disproportionate burden on the poor.

Progressive. A progressive tax is a tax that charges a higher percentage of income as income rises. Examples of progressive taxes are federal and state income taxes. For example, if person A makes $10,000 a year and pays $1,500 in income taxes, that person’s tax burden is 15%. If person B makes $100,000 and pays $28,000 in income taxes, then that person’s tax burden is 28%.

Proportional. This tax is sometimes called the flat tax. A proportional tax is a tax that charges the same percentage of income, regardless of the size of income. For example, if person A makes $10,000 and pays $1,500 in taxes, that represents 15% of his/her income. Person B makes $100,000 a year and pays $15,000 in taxes, that also represents 15% of income.

The issue of fairness is always brought up when looking at these types of taxes. Many people think the flat tax would be the most fair. But before we can make an accurate judgment, the concept of disposable income must be discussed. Disposable income is income left after paying taxes. This represents the money that an individual can use to make purchases for both necessities and luxuries. For the example above, the person making $10,000 a year has $8,500 left to live on after paying 15% of income in taxes. That means he/she will be using most of that money for eating, living, and transportation expenses, leaving little to use for self-improvement, such as taking college courses. The person making $100,000 a year will have $85,000 left after paying 15% in taxes to live on. This person may spend that same amount or slightly more than the first person on eating, living, and transportation expenses, leaving a substantial amount for luxury items. This is why some economists argue that a flat tax is really a regressive tax in disguise.

The Federal Income Tax. For part of our nation’s history, citizens of the United States did not pay personal income taxes. It wasn’t until 1913 that the 16th Amendment gave the federal government the power to tax individual income. In 1913 the top tax rate was 7%, meaning that you only paid 7% of your income in taxes, and it didn’t start until after you made $500,000. It wasn’t until after World War II that the average working person even paid a federal income tax. In the 1980’s under the Reagan Administration, the rates for the top income level was cut from 70% to 28%. Under the Clinton Administration, the rates for the top income level went up to 39.6%. The Bush Administration reduced the top rate to 35%. In December of 2012 with the “Fiscal Cliff” negotiations, the top rate was raised back to 39.6% for those with incomes over $400,000. By looking at the tax table below, one can notice that poor people pay little or no personal income tax and that the wealthy pay more than the poor. But what hurts the poor is the payroll tax which will be discussed next.

The Payroll Tax. The payroll tax represents the Social Security and Medicare taxes that you pay. If you look on your check, 7.65% of your wages are deducted to fund Social Security and Medicare. Your employer also pays a matching 7.65% of your wages into the same fund. The payroll tax is the fastest growing source of revenue for the federal government. In recent years, the ceiling has been raised to match the rate that the consumer price index rose. This has the effect of making permanent the regressive nature of the payroll tax. Keep in my mind from the discussion above, that regressive taxes hurts the poorer segments of our society more than the better off segments of our society.

For the year 2017, earners stopped paying a social security tax after they earned $127,200. Which means that a 6.2% deduction for Social Security is not taken out for every dollar earned above $118,500.

The Incidence of the Social Security Tax at Various Income Levels in 2017 in the United States

Level of Earned Income

Taxes Paid

Average Tax Rate

$ 10,000

$ 620.00

6.2%

127,200

7,886.40

6.2%

500,000

7,886.40

1.58%

1,000,000

7,886.40

0.78%

* The Social Security tax rate is set by law at 6.2%. Each year, however, the inflation rate of the previous year raises the wage base.

In recent years, the social security tax has been under criticism. When social security was created, it was set-up as a “pay-as-you -go” system. In other words, current workers pay for people who are currently retired. This means that social security redistributes income from one generation to another. When the social security tax was first implemented, the rate was 5 % ( 2 1/2% from the employee’s check, and 2 1/2% from the employer). Today the rate is 15.3%. The increase is in part due to changing demographics. In 1945, there was a 50 to 1 worker to retiree ratio. Today, that worker to retiree ratio is 3 to 1. It is expected to be 2 to 1 by the year 2030. It is estimated that the tax rate would have to rise to 21% for everyone to receive full social security benefits. This also means that the average inflation adjusted rate of return for each new generation is decreasing. In other words, the Baby boomers will get less money in benefits than they put in compared to the generation before them, Generation X will get less than the Baby boomers, and so on and so on.

Corporate Income Tax. With the payroll tax becoming the second leading source of income for the federal government after the income tax, what tax, then did the payroll tax pass up? The corporate income tax used to occupy second place. The Tax Reform Act of 1986, lowered the rates corporations pay from 46% to 34%. The federal corporate income tax differs from the individual income tax in two major ways. First, it is a tax not on gross income, but on net income or profits, with permissible deductions for most costs of doing business. Second, it applies only to some businesses—those chartered as corporations—and not to partnerships or sole proprietorships. The chart below shows how in the United States over the past 60 years, that the percentage of income taxes paid by corporations has decreased, while the percentage paid by individuals has increased.

Excise Taxes. Excise taxes are federal taxes directed at specific goods. Items taxed by the federal government under the definition of an excise tax include tires, phone calls, cigarettes, gasoline, and liquor. Excise taxes account for about 3% of federal revenue. But there is another reason these items are taxed. Sometimes an excise tax may be referred to as a “sin tax”. If the government wants to discourage consumption of an item that is legal, then they can levy an increase in its tax. In recent years, this has been the case for cigarettes. Excise taxes are generally regressive, their burden falling more heavily on the poor.

Estate Taxes. One of the oldest and most common forms of taxation is the taxation of property held by an individual at the time of their death. Such a tax can take the form, among others, of estate tax (a tax levied on the estate before any transfers). An estate tax is a charge upon the decedent’s entire estate, regardless of how it is disbursed. Most Americans do not have to worry about paying taxes on an estate until after it reaches a specific dollar amount: for 2017 the exemption rose to $5.49 million a person and $10.98 million a couple. This means that a person inheriting an estate worth $5.49 million would only pay a tax on the portion in excess of the limit. William Gates Sr., father of the wealthiest person on the planet, and who would have more to gain than anyone else from the repeal of the estate tax, has gone on the lecture circuit to voice his support of keeping the estate tax. Visit the links below for more information.

As with most taxes there is debate over the estate tax. Those who oppose it call it the “death” tax. They see it as government interference. They believe parents would be able to will to their children whatever sum they wish, without the government getting any. Others claim the family farm will be lost if the value of the farm is too high. Those who favor the estate tax claim the wealthy have found ways to avoid paying taxes earlier and the estate tax catches that untaxed income. If the estate tax goes away, then it will mean $1 trillion less dollars coming into the federal treasury, further adding to the budget deficit.

Capital Gains Tax. A capital gains tax is a tax assessed on the profits made from the sale of a capital commodity, such as stock or real estate. The tax is only paid when the commodity is sold. The capital gains tax represents about 5% of federal revenue. Taxpayers in the 10 and 15 percent tax brackets pay no tax on long-term gains on most assets; taxpayers in the 25-, 28-, 33-, or 35- percent income tax brackets face a 15 percent rate on long-term capital gains. For those in the top 39.6 percent bracket for ordinary income, the rate is 20 percent.

There has been a movement in the United States to either lower or abolish the capital gains tax. Supporters believe such a move would stimulate investment in new companies. Opponents say it is a tax gift for the wealthy. Visit the links below to learn more.

The Sales Tax. The sales tax is a tax by individual states on the purchase of specific goods and services. Some items such as food are exempt, meaning most items purchased entail a sales tax. The vast majority of taxes collected by states come in the form of sales taxes. Remember from the discussion above, that sales taxes are regressive. The poor use a higher proportion of their income on daily necessities, in comparison to the rich who are able to save more.

The Property Tax. The property tax is the largest source of revenue for localities. It is a tax on residential homes, commercial buildings, and land. Property taxes are used to fund city governments, schools, as well as police and fire departments. Many people in the United States believe that property taxes are too high.

It is the duty of American citizens to monitor tax fairness and to ask the question “am I paying too much in taxes?” Contrary to popular belief, Americans are not heavily taxed if we compare them to citizens in other industrialized countries. Why then, is there a lot of complaining about taxes? It might be because of the perceived benefits we get in return for our taxes. In many of the heavily taxed European countries, their tax dollars brings them free universal health care, comfortable retirement pensions, free college tuition, and subsidized day care. According to a report from Citizens For Tax Justice, in 2010 total federal, state and local taxes in the United States were 24.8% of our gross domestic product, ranking among the bottom of 30 OECD countries.

Because both citizens and economists are concerned with issues of equity and efficiency, there has been an ongoing discussion about tax reform. The discussion below is a thumbnail sketch of some of the different tax reform ideas being promoted.

1. Improve the Current Income Tax System. This idea is supported by those who believe in the ability-to-pay principle and progressive taxes. The idea that if you make more you should be taxed more seems to appeal to a large number of Americans. This system emphasizes equity (tax burden being shared) but not efficiency ( avoidance of paying taxes through tax loopholes). Supporters say the main improvement needed is to close tax loopholes. If taxpayers, whether individuals or corporations, would pay what they are supposed to pay, then tax revenues would be greater and the tax burden on those who do pay would decrease.

2. Adoption of a Flat Tax. Supporters of this reform believe the current income tax system to be both unfair and complicated. They believe the current system is grossly inefficient. Hundreds of billions of dollars are wasted every year, and billions more go uncollected because of tax evasion, or because of mistakes and oversights due to complex and ever-changing tax laws. There are also billions of dollars of tax revenue lost because of black market or illegal cash transactions. Most flat tax proposals propose a set percentage tax rate to be applied to all taxpayers. In 2012 Republican presidential candidates Herman Cain, Newt Gingrich and Rick Perry and Vice Presidential candidate Paul Ryan all supported a flat tax.

Individuals and businesses would pay the same rate. Flat tax plans eliminate all deductions and credits. The only income not subject to tax would be a personal exemption that every American would receive. . When the exception begins differs from plan to plan. Most proposals run from 20 – 28%. There are no loopholes for powerful lobbies. There would be a simple tax system that treats every American the same.

3. Consumption Tax. Many people in the United States would like to move to a consumption tax. A consumption tax is a tax on spending, rather than on income. Most countries in the world, including Canada and most European countries, use a consumption tax. The most common form of a consumption tax is the value added tax (VAT). A value added tax collects the difference between what companies earn in revenues and their previously taxed costs. For example, a wheat farmer would pay a tax on the difference between revenues from the sale of the crop and the costs of fertilizer and other materials used to grow it. The price of a final product is nothing more than the sum of the values (taxes) added. A small tax of say 5%, is added as value is added. So the wheat farmer pays 5%, the maker of a loaf of wheat bread pays 5%, the grocery store which sells the wheat bread pays 5%. As a consumer buying a loaf of wheat bread then, 15% of the cost of the bread is in value added taxes. The value added tax ends up being a sort of hidden, national sales tax. For the most part, citizens in countries with a value added tax, do not pay individual income taxes. Advocates say consumption taxes increase the incentive to save, and could promote national savings in the United States. Click on the links below for more information on the value added tax.

Governments, through the use of fiscal policy, will attempt to stabilize an economy or promote growth. Sometimes this effort produces a side effect: a budget deficit. Our government has been in debt for the majority of its history. Most polls show that the American public believes deficits are irresponsible and the federal government should balance its budget. If you want to learn more about the United States federal budget and deficits, click on the link below.

The environmental standards mentioned above are one form of government regulation. Extensive government regulation occurs in industries where there is deemed to be a public good. Regulation consists of rules developed by a government agency to influence economic activity by determining prices, product standards, and conditions under which new firms may enter the market. The first national regulatory agency was the Interstate Commerce Commission (ICC) established in 1887. Over the next 90 years the regulation of the economy grew to include banking, telecommunications, utilities, railroads, trucking and the airline industries. Beginning in the early 1980’s, many of these industries underwent deregulation. Deregulation is the process of removing restrictions on prices, product standards and entry conditions.

The Case for Regulation and Deregulation

Why would the government want to step in and regulate an industry? One example would be when dealing with natural monopolies such as public utilities. Because of the large economies of scale, meaningful competition is impossible. The government uses regulation to ensure that output meets consumer demand. If regulation benefits a large number of people and the recipients notice the benefits, then politicians are likely to support the regulation. Another example would be to expand the scope of service (bring in either more suppliers, or to expand the number of consumers who benefit from the public good). Finally, the government might regulate an industry for a social benefit. Such regulation would be an attempt to correct an undesirable side effect of the market that would relate to health, safety, or the environment. Examples of social regulation would be the Environmental Protection Agency, the Consumer Product Safety Commission, the National Highway Transportation Safety Administration, the Food and Drug Administration and the Occupational Safety and Health Administration.

Over the past few decades, there have been dramatic changes in the way the U.S. economy is regulated by the government. Many economists and politicians believed that many businesses were over regulated. The purpose of deregulation is to increase price competition and provide new incentives for companies to introduce new products and services. There is disagreement amongst economists if deregulation works. If we look at the deregulation of the airline industry, we see mixed results. In the beginning, consumers benefited from lower air fares. But in the last few years, we have seen many airlines going bankrupt, discontinue routes, an increase in cancelled flights, and long waits.

Mergers

A special type of government regulation is mergers. A merger is the joining of two firms who produce a similar product. The Federal Trade Commission uses guidelines to determine which mergers it will examine and possibly block. These guidelines use a mathematical formula (Herfindahl-Hirschman Index) to has enough competition for a merger to be allowed. In May of 2016 a federal judge sided with the Federal Trade Commission and blocked the proposed merger between Office Depot and Staples. The FTC decided that the market would be too concentrated, lead to higher prices and would lack competition, so it blocked the merger.